Kass: Confronting Fear

This commentary originally appeared on Real Money Pro on Nov. 18 at 9:15 a.m. EST.

In my opening missive yesterday on Real Money Pro, I expressed the following:

One of the differences I have with the bears now is that I expect, before the problems in Europe get too worrisome and out of hand, that the ECB will ultimately step up by lifting its purchases of Italian and Spanish bonds, will further cut targeted interest rates and will introduce a large quantitative-easing program, so I am willing to look over the valley of eurozone uncertainty.

To date, the ECB has been tame and timid, so the speculators and bond vigilantes in Europe have continued to put pressure on sovereign debt prices until the ECB enters the shock-and-awe phase.

Shock-and-awe will come sooner than later; the adverse economic ramifications and poisoning/collapse of the European banking industry are alternatives that will ultimately be unacceptable to Europe's leaders and populace.

I went on to write:

I am using the stock market weakness in days such as Wednesday to increase my overall net long position, as I believe that, in the fullness of time, not only will the ECB be pressured to do the right thing but the high-frequency economic data in the U.S. (regional ISMs, durable goods, leading indicators, etc.) are supportive of a much better domestic economic and corporate profit growth outlook than that on which the bears are feeding.

For now, the "gathering strength" in our country that Jim Cramer describes is being ignored, as the pessimists embrace the European headlines (and, in yesterday's case, a dated statement from Fitch on U.S. bank exposure to Europe). So are multidecade undervaluations (relative to interest rates and inflation) being ignored with record-high risk premiums (earnings yield less the risk-free return).

So, another reason why I disagree with the bears is that I am willing to look beyond the European mess, believing, as I do, that the strengthening in the U.S. economy will eventually trump Europe's woes (which, as mentioned previously, will be addressed).

Later in the day, I expressed that fear has entered the marketplace.

Investors are fearful of (in order of importance):
the eurozone's continued debt crisis;
a liquidity squeeze in which banking credit is cut off;
the perception that Republicans and Democrats in the Super Committee will fail to make the needed compromises; and
a technical breakdown in the averages.

Above all, the eurozone's debt contagion has weighed on the markets and has trumped improving economic data. Secondarily, all our economic hopes over here have centered on the division in Washington, D.C.

But, for me, I continue to be willing to look over those valleys -- for as the wise man, once said, "This too shall pass."

So, let's confront the fear.

Specifically, and to be truthful, if I were Germany's Merkel, I would be behaving in the same manner as she. Keeping Greece's and Italy's feet to the fire as long as possible has resulted in larger austerity cuts in Greece and will likely result, in the fullness of time, in the same for Italy.
At that time, we can finally begin to call an end to the euro crisis.

Toward that end, Dow Jones just reported:

A proposal that the IMF could call on the ECB to lend it money so it can finance bailouts for euro zone governments threatened with insolvency is gaining traction and if all parties agree, a deal could be announced at the Dec. 9 European Union summit, two people with direct knowledge of the matter said....

Germans and the ECB are still opposed to the idea, but with no other viable alternatives, talks could start soon.

As a result, S&P futures just spiked, and European sovereign debt yields have come in.

As to the division between the Republicans and Democrats, it, too, will be resolved -- it is mandated. And as the escalation in Europe's crisis manifests itself in higher sovereign bond yields (and borrowing costs) and riots, it is unreasonable to think that this is being lost on our crew in Washington. Moreover, as First Trust's Brian Wesbury writes, the Super Committee is much ado about little:

We don't watch that much television, but every time we turn on cable news, someone is talking about the Super Committee -- the 12 members of Congress tasked to cut the deficit over the next 10 years by $1.2 trillion. Supposedly -- at least according to the talking heads -- the Super Committee is the biggest and most important issue facing the economy. One news anchor said that committee decisions will determine how retailers do this year during the holiday shopping season. Others are trying to make the case that failure to come to agreement threatens another recession. Pardon me when I say -- "Give me a break."

According to the Congressional Budget Office, total federal government outlays in the next 10 years (2012-2021) are expected to be $44 trillion, while GDP will total $195 trillion. If we assume that the committee does not raise taxes at all, which means the $1.2 trillion is all spending reduction, this would equal just 2.7% of the budget, and 0.6% of GDP.

To me, the dual situations are so bad it's good. By that, I mean that nearly every investor I know is now skittish (as volatility has spiked). As a manifestation of sentiment/fear, retail and institutional investors have materially de-risked and are uncommitted to investing long term in our markets. While those classes of investors can't be blamed for their pessimism, they also might me missing opportunity.

As evidence of this possibility, consider the following from Charles Schwab (hat tip to subscriber Sir David Rolfe who called this to my attention):

The final technical chart brings in volatility. On Friday, the market experienced the 17th time in the past three months that the S&P 500 SPY (exchange-traded fund trading the S&P 500) gapped by more than +/- 1% at the open and then didn't close that gap during the day. This means that the S&P didn't reverse enough to "kiss" the previous day's close. As you can see in the chart below, this level of "unclosed gap" behavior has been seen only four other times since the early-1990s. All occurred while the market was forming a major bottom.

And from SentimenTrader (hat tip Cullen Rolfe, Pragmatic Capitalism):

The second chart shows the two-month moving average for the VIX. Current readings (pardon the 24-hour-old chart) are consistent with buying points on a 24-month basis. Granted, there are only three data points in the last 20 years, but the readings are consistent with high pessimism, which tends to be consistent with being closer to a market bottom than top. Additionally, this is only one of many indicators that the modern-day investor should track. Nonetheless, it's worth keeping in your tool belt.

Now, I can't say that I am eating the cooking here because I still abide by my balance sheet recession trading approach, but it's food for thought for the longer-term investor....

I am not saying that I am thrilled to watch the market's inconsistent and volatile activity every day or its late-day swoons. It is painful, but fear is a necessary reagent and is typically the precedent to up legs in the markets.

But I am saying, in essence, that I would not be overwhelmed by Mr. Market's daily trials and tribulations, as I believe that the bigger picture is setting up for a strong up move.

As to the third point I made above, the technical setup might be positive as well. I want to update George Lindsay's "Three Peaks and a Domed House" (superimposed upon S&P cash). The chart below indicates that the technical pattern continues to be almost perfect. If history follows we are about to move toward the domed house (and much higher stock prices) in the months ahead.

To summarize, while no man, country, or stock market can be considered an island -- and I fully recognize the potential risks in Europe -- I am more greedy than I am fearful now.